TAILIEUCHUNG - WORKING PAPER NO 13 CREDIT RISK TRANSFER AND FINANCIAL SECTOR PERFORMANCE Wolf Wagner & Ian Marsh

Dobrinsky et al. (2001) conjecture that some specific types of soft budget constraints in a transitional environment may emerge as a result of distortions in incentive structures. In particular, distorted incentives may have an effect both on the determinants of credit supply and credit demand. 2 In turn, incentive structures are a reflection of the institutional environment and the conduct of economic policy in the broader sense. Consequently, policy reforms and policy shocks can be expected to affect the determinants of credit flows both on the supply and the demand side. The empirical research in this area is confronted with. | WORKING PAPER NO 13 CREDIT RISK TRANSFER AND FINANCIAL SECTOR PERFORMANCE Wolf Wagner Ian Marsh The Working Paper is intended as a means whereby researchers thoughts and findings may be communicated to interested readers for their comments. The paper should be considered preliminary in nature and may require substantial revision. Accordingly a Working Paper should not be quoted nor the data referred to without the written consent of the author. All rights reserved. 2004 Wolf Wagner Ian Marsh Comments and suggestions would be welcomed by the authors. e-mail Wolf Wagner Ian Marsh i. marsh@ Credit Risk Transfer and Financial Sector Performance Wolf Wagner and Ian w. Marsh Abstract In this paper we study the impact of credit risk transfer CRT on the stability and the efficiency of a hnancial system in a model with endogenous intermediation and production. Our analysis suggests that with respect to CRT the individual incentives of the agents in the economy are generally aligned with social incentives. Hence CRT does not pose a systematic challenge to the functioning of the hnancial system and is generally welfare enhancing. However we identify issues that should be addressed by the regulatory authorities in order to minimize the potential costs of CRT. These include ensuring the development of new methods of CRT that allow risk to be more perfectly transferred setting regulatory standards that reflect differences in the social cost of instability in the banking and insurance sector promoting CRT instruments that are not detrimental to the monitoring incentives of banks. JEL classifications E44 G21 G22 G28 Keywords credit risk transfer financial stability and efficiency regulation We thank Mathias Drehmann Alan Morrison Norvald Instefj0rd Demosthenes Tambakis and seminar participants at Cambridge University Lancaster Business School and at the FSA for helpful comments. Corresponding author. Cambridge Endowment for Research in Finance

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